Wednesday, October 29, 2014

Riksbank and ECB: reverse asymmetry

The Swedish central bank just lowered interest rates to zero because of deflation risks. This action comes after ignoring repeated warnings from Lars Svensson who had joined the bank in 2007 and later resigned because of disagreements with monetary policy decisions. What it is interesting is the parallel between Riksbank decisions and ECB decisions. In both cases, these central banks went through a period of optimism that make them raise interest rates to deal with inflationary pressures. In the case of Sweden interest rates were raised from almost zero to 2% in 2012. In the case of the ECB interest rates were raised from 1% to 1.5% during 2011. Also, in both cases, after a significant expansion in their balance sheets following the 2008 crisis, there was a sharp reduction in the years that followed. During 2010 the balance sheet of the Riksbank was reduced by more than 50%. In the case of the ECB it was later in 2013 when the balance sheet shrank by about 1 Trillion Euros. Their policies stand in contrast with those of the US Federal Reserve and the Bank of England where interest rates still have to start going up after the initial actions taken during the crisis and where the expansion in their balance sheet has not started to being reversed.

The consequences of the policies of the ECB and Riksbank are clear: a continuous fall in their inflation rates that has raised the risk of either a deflationary period or a period of too-low inflation. What is more surprising about their policy actions is their low speed of reaction as the data was clearly signaling that their monetary policy stance was too tight for months or years. In both cases their decisions to bring down their interest rate or take further action has happened in very small steps. And every time a step is announced the reaction has always been asking what will be next. So the announcement of the Riksbank has now been met with questions about when they will have to start their own version of QE. Same as for the ECB where their latest announcements has led to expectations of future more aggressive actions.

What we learned from these two examples is that central banks are much less accountable than what we thought about inflation targets. And they make use of the lack of clarity on the exact definition of their targets to produce a policy that is clearly asymmetric in nature. Taking some time to go from 0% inflation to 2% inflation is ok but if inflation was 4% I am sure that their actions will be much more desperate. In the case of the ECB their argument is that the inflation target is defined as an asymmetric target ("close to but below 2%"). But this asymmetry, which was never an issue before the current crisis, has very clear consequences on the ability of central banks to react to deep crisis with deflationary risks.

What we have learned during the current crisis is that an asymmetric 2% inflation target is too low. Raising the target might be the right thing to do but in the absence of a higher target, at a minimum we should reverse the asymmetry implied by the ECB mandate. Inflation should be close to but above 2% and this should lead to very strong reaction when inflation is persistently below the 2% target.

Antonio Fatás

Wednesday, October 1, 2014

The permanent scars of fiscal consolidation

The effect that fiscal consolidation has on GDP growth has probably generated more controversy than any other economic debate since the start of the 2008 crisis. How large are fiscal multipliers? Can fiscal contractions be expansionary?

Last year, Olivier Blanchard and Daniel Leigh at the IMF produced a paper that claimed that the IMF and other international organizations had underestimated the size of fiscal policy multipliers. The paper argued that the assumed multiplier of about 0.5 was too low and that the right number was about 1.5 (the way you think about this number is the $ impact on GDP of a $1 fiscal policy contraction).

While that number is already large, it is possible that the true costs of fiscal consolidations are much larger. In a recent research project (draft coming soon) I have been looking at the effects that fiscal consolidations have on potential GDP. Why is this an interesting topic? Because it happens to be that during the last 5 years we have been seriously revising the level (and in some cases the growth rate) of potential GDP in these economies. And while there might be good reasons to do so, the extent to which we have done this is dramatic and one gets the sense by analyzing the data that what is really happening is that the cyclical contraction is just leading to a permanent revision of long-term GDP forecasts (I wrote about this in my latest post).

To prove my point I decided to replicate the analysis of Blanchard and Leigh but instead of using the forecast error on output growth, I used the forecast error on potential output changes. Here are the details, which follow Blanchard and Leigh as close as I can: I take the April 2010 issue of the IMF World Economic Outlook and calculate:
- The predicted fiscal consolidation over the next two years (2010-11)
- The expected change in potential output over the next two years (2010-11).

I then look at the actual change in potential output during those years (2010-11) as presented in the April 2014 IMF World Economic Outlook. Comparing this figure to the forecast done back in April 2010, we can calculate for each country the forecast error associated to potential output growth.

Most models assume that there should be no correlation between these two numbers. Fiscal consolidations affect output in the short run but not in the long run. But under some assumptions (hysteresis or growth effects of business cycles) cyclical conditions can have a permanent effect on potential output (I have written about it here). So what is the evidence?

If we include all European countries that are part of the Advanced Economics group as defined by the IMF we get the relationship depicted in the graph above. There is a strong correlation between the two variables: fiscal consolidations have led to a large change in our views on potential output. The coefficient (strongly significant from a statistical point of view) is around -0.75.

Just for comparison, and going back to the original work of Blanchard and Leigh, the coefficient using output growth (not potential) is around -1.1. Because the forecast for output growth already included a multiplier of about 0.5, Blanchard and Leigh's interpretation was that the IMF had been underestimating multipliers and instead of 0.5 the true number was 1.6. In my regression, the theoretical multiplier built into the IMF model must be zero, which means that the true long-term multiplier is just the coefficient on the regression, about 0.7. But this number is very large and it provides supporting evidence of the arguments made by DeLong and Summers regarding the possibility of fiscal contractions leading to increases in debt via the permanent effects they have on potential output.

There are many interesting questions triggered by the correlation above: What are the mechanisms through which potential output is affected? Is potential output really changing or is just our perception about long-term growth that is changing? These are all interesting questions that I hope to address as I translate the analysis into a proper draft for a paper. To be continued.

Antonio Fatás